Brother in law's guide: Why fudging the fixed vs floating decision makes sense (Update: January 13)

By Bernard Hickey Here's the short version: Fixed mortgage rates are rising, but it's possible variable mortgage rates could stay below fixed rates until later this year. Those choosing to go fully fixed for a 2 or 3 year term are betting the OCR will rise quickly above 5% by the end of 2010 or early 2011 from 2.5% now. That is possible if the economy recovers as strongly as most economists now expect and given it has averaged 6% since 1999. (Updated January 13) Those choosing to go completely variable are betting the OCR will stay below 5% until at least late 2010, which is possible if the global economy remains stagnant and New Zealand's economy recovers fitfully. I'd say to my 'brother in law' the safest bet right now is to split the mortgage into half variable and half 2 year fixed to allow early repayment and to reduce the risks of either a sudden move up in the OCR or no move at all. Here's the long version below

I'm going to regularly review the various mortgage rates on offer and examine the types of decisions any homeowner has to make. Every homeowner is different with different income situations and different needs for certainty. Some may want to take a punt on interest rates, while others are simply looking for the cheapest deal right now, or both. So I'll look at one 'type' of home owner and any reader can make up their own mind whether this applies to them. I'm going to call this type my 'brother in law'. This home owner is living in the home, has a couple of young kids, one and a half incomes, and a desire to keep interest costs as low and as predictable as possible, while at the same time retaining some flexibility for debt repayment from bonuses, payouts and inheritances. Where will interest rates go? The first decision any home owner has to make before deciding what type of mortgage, what bank and what rate they want is what they think will happen to interest rates. Fixed mortgage rates are determined by what happens in wholesale interest rate markets, what happens in retail deposit rate markets and how much profit banks want to make. That's plenty of variables right there, but unfortunately for punters there's plenty more variance underneath that. For example, wholesale interest rates are effectively the market's judgement on where the Official Cash Rate (OCR) will be at a certain period in the future. The OCR, in turn, is decided by the Reserve Bank of New Zealand Governor Alan Bollard. His role is to keep the inflation outlook between 1 and 3% over the medium term. So traders and economists in these wholesale markets try to second guess Bollard on what he's thinking now about the growth and inflation outlook and what might happen in the future. The global economic outlook also has to be thrown into the mix because that can affect the New Zealand economy and sometimes cheap foreign money can flow into our wholesale money markets and push rates down. Another variable is New Zealand's sovereign credit rating. If it was downgraded our wholesale interest rates would rise. The longer the fixed mortgage term, the more variables come into play. For example, the Reserve Bank announced in June 2009 that banks would have to raise more of their funds locally and more of it at longer terms. This effectively pushed up the funding costs for banks and they have passed that on in the form of higher fixed mortgage rates. No one can be particularly sure either what the banks will want to do with their profit margins. They have been falling for the last couple of years. That may not last. Fixed interest rates are rising, but floating rates may be hold for another 3 months The OCR has been unchanged at a record low of 2.5% since April 30, 2009 and the Reserve Bank has pledged four times since then to keep the OCR at or below 2.5% until the middle of 2010. If the RBNZ sticks to its promise, that means the OCR, and therefore variable mortgage rates, are unlikely to rise until June 10, although markets reckon a March 11 hike is possible. The next Reserve Bank statement on the OCR is on January 28. However, fixed mortgage rates rose sharply in the last 8 months of 2009, particularly longer term fixed rates. In the past many homeowners and banks opted for 2 year fixed rates. The average bank 2 year rate has risen from around 5.9% in mid February 2009 to around 7.2 % now, while 5 year fixed rates have risen from around 6.5% in mid-February to around 8.7% now. Fixed mortgage rates have averaged around 8% over the long run in New Zealand, so anything below 8% would appear cheap, unless you believe New Zealand and the world is likely to face permanently lower interest rates for years to come. We are now in an historically unusual position where floating and very short term mortgage rates are cheaper than longer term mortgage rates. In the past the 'easy' decision was to opt for a longer term rate. Now that decision is not so easy. Those people who want the 'certainty' of a fixed rate for a longer period will have to pay more for that certainty and will have to take a conscious decision to pay more in the expectation that variable rates will be higher than their fixed rate for a good chunk of the fixed period. Currently the lowest mortgage rates are variable and around 5.8%, while the best 2 year fixed rates are around 7.2%. This means that anyone taking out a 2 year fixed rate is assuming that the variable rate will be higher for at least the last year of the two year term. That would imply an OCR of around 5% late in 2011. That is possible, but would imply quite fast increases in the OCR in late 2010 and early 2011. However, it shouldn't be forgotten that the OCR has averaged 6% since its introduction in 1999. Anyone making the decision about a 2 or 3 year mortgage right now is taking a decision that the OCR will rise quickly from mid 2010 and keep rising through 2011. Anyone deciding to stick solely with a variable rate is assuming the OCR will stay at or below 5% for the next two to three years. That is also possible, but less likely in my view. I believe there is too much stimulus in both the global and local economies, which will force central banks to quickly tighten money policy from early to mid 2010, particularly in New Zealand where the housing market is bubbling again because of cheap interest rates. The risk to that view is if the global economy fails to recover quickly and stagnates. There is another way One way for my fictional 'brother in law' to have his cake and eat it is to split the mortgage. My brother in law wants to repay his mortgage as fast as possible and understands that repayments now save much more over time than waiting until the end of a fixed term to repay, even if the interest rate is a bit cheaper. There is the possibility of bonuses or redundancy payouts or inheritances that he wants to use to pay off the mortgage quickly. One option is to split the mortgage into a fixed portion and a floating portion. This reduces the risks of being caught horribly by either interest rates rising sharply over 5% or not moving at all. It also allows early repayment. The rates now (Updated January 13) BNZ has the lowest variable rate at 5.59% for its Total Money loan, while ANZ has a 5.69% simple variable rate (only for 80% or lower loans), ASB has a 5.75% regular variable rate, Kiwibank has a 5.79% standard rate and National has a 5.75% regular variable rate. Westpac has a 5.69% Choices Everyday variable rate and a 6.29% standard variable rate. At the moment I would suggest my brother in law keeps half floating and half fixed for around 18 months to 2 years. That's about as long as you can reliably think about the future of interest rates and the 18 month rates are looking reasonably good value at the moment. Kiwibank has the lowest 18 month rate at 6.39%, while National is at 6.60%, Westpac is at 6.59% and BNZ is at 6.59%. ANZ is at 6.69% and ASB is at 6.75%. The absolute cheapest combination (although I suspect my brother in law would want to keep both mortgages with the same bank for ease of service) is for a BNZ Total Money variable mortgage with a Kiwibank 18 month rate. Kiwibank and BNZ have the most competitive combinations.